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November 1, 2011

Is There Still a Payoff for the Quality Premium in Stocks? An Analysis

Over the last couple of years, we’ve all heard how the collective rush to low-quality stocks has left active, long-only equity managers in a vacuum. True enough, from March 2009 to June 2011 the S&P 500 Low Quality Index outperformed the S&P 500 High Quality Index by an astonishing 1,100 basis points. Since so many of the managers we cover at Prima Capital have a high-quality bias, it’s particularly important that we understand the logic behind this reality, if there is any. To that end, we want to take this opportunity to dig a little deeper into the ‘high quality versus low quality’ debate to see if there really is a payoff for the so-called quality premium.

First, let’s set an acceptable definition for quality. Given that the vast majority of professional money managers use the S&P Quality Rankings to characterize their common stocks, we believe this is the best definition for quality. More than that, the Quality Rankings, which by S&P’s definition reflect the long-term growth and stability of a company’s earnings and dividends, can also be used as a proxy for risk. Several academic studies, most notably those of Muller and Fielitz in 1987 and Felton, Liu and Hearth in 1994, found a close relationship between a common stock’s S&P Quality Ranking and its beta and standard deviation of returns.

With all of that as a given, we can then hypothesize this: High-quality biased strategies should provide above-average downside capture statistics and below-average upside capture statistics.

What Do We Know?

As the chart below shows, high-quality stocks, with the exception of 2008, protected investors on the downside and trailed the gains associated with low-quality rallies. We consider the outlying year to be unique in that the massive hedge fund de-leveraging brought on by the credit crisis put outsized pressure on high-quality stocks. The resulting price declines reversed themselves in 2009, allowing investors to recoup these losses.

Our internal analysis of the Morningstar mutual fund universe supports this observation. Employing a broad range of quality factors, including ROE, low debt-to-capital ratios, high and consistent dividend yields, and long-term earnings growth, we found a statistically significant relationship between quality and the direction of the market.

Of course, now that we know when the quality premium should work, just how do we use this information? First of all, we should view quality in the same light we view other factors like size and style in that it is subject to rotations in various market environments. In other words, quality—just like other risk and reward factors—does not provide a consistent payoff. In fact, payoff may not exist for extended periods of time. Across the decade from January 2000 to December 2010, for example, low-quality stocks actually outperformed high-quality stocks by 1.48% (annualized). More recently, however, the quality premium has been very much in vogue…in the third quarter alone, high-quality stocks outperformed low-quality stocks by approximately 10%.

It’s difficult to predict with any certainty how long the current trend will continue as it will

be highly dependent on the economy and the broader stock market. Still, we can conclude that high-quality biased strategies are doing a relatively good job of preserving capital right now, which to many investors, especially those with shorter time horizons, may be of primary importance when selecting a long-only U.S. equity investment.

What Do We Do?

While we don’t even pretend to have a crystal ball that actually works, there are some unique developments today that tell us a lot about the potential return profile of high-quality stocks. One of the more unusual is the relationship between dividend yields and the average 10-year Treasury yield.

As the graph shows, dividend yields for the S&P 500 Index are in line right now with the average 10-year Treasury yield. Believe it or not, the last time these two yields were the same was in the 1950s. Given this relationship, we wouldn’t be at all surprised to see a dramatic new interest in dividend-paying stocks as investors search for yield. We’ve already seen a significant divergence this year between higher-yielding stocks and the overall market, as evidenced by the outperformance of the Dow Jones Select Dividend Index versus the S&P 500 Index.

So is there a payoff for the so-called quality premium? Our analysis says yes…in time. And today might indeed be a good time. Between the search for yield due to historically low fixed-income rates, the significant valuation gap between high-quality and low-quality stocks, and the anticipated slow growth environment, we could see higher quality stocks outperform—no matter the direction of the market.

Author’s disclaimer: The views and opinions expressed are provided for general information only and do not constitute specific investment advice or recommendations from the author.

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